Mental models guide your way

Mental models guide your way

Throughout the last years, working in financial markets, I sometimes struggled with the amount of information raining down on me. Due to the constant news flow and wave of quotes, making sense of markets and execute your strategy can be difficult.
Searching for ways to be more focused and consistent, I discovered the concept of mental models. Through their application, I’m able to process information more efficiently and see through the fog of war. In essence, Mental models describe general thinking principles of how the world around us is working. They are used in almost any domain, be it economics, physics, or biology. Mental models are deeply rooted in the evolutionary tendency of our brains to generalize from information. They help us make sense of the world and guide us to make better and more consistent decisions. They reduce complexity which in return frees up brain capacity.
Due to my curiosity regarding a wide range of different subjects, I intend to acquire as many mental models as possible. Ideally, one can combine the various models from different disciplines (e.g. physics, biology, and economics) and weave a multidimensional network of principles. The more mental models you acquire, the more you can make sense of the things going on around you. This effect also can be seen in the collaboration of multidisciplinary teams. People with different backgrounds bring different mental models to the table which can increase overall decision-making quality.
One vivid example of the value of combining different mental models is the application of evolutionary theory to financial markets. There is a variety of different market participants using different investment strategies. In the course of time, profitable investors survive while unsuccessful ones lose their capital and get extinct.  Markets behave with respect to the current ecosystem of participants and investment strategies.
A recent resemblance of this phenomenon is the investment strategy of volatility selling which was used heavily in equities over the past few years. Market participants would generate a steady income stream by selling options or combinations thereof and only would lose money if a significant rise in volatility would occur. The extensive utilization of this strategy led to a low volatility market environment, which in turn was perceived as confirmation of success. In February of 2018 short vol strategies were put to a test, when volatility markets blew up, a number of market participants were wiped out, and markets switched to an overall more volatile regimen. After trending down again for more than two years, COVID-19 send volatility skyrocketing and bankrupted even more investors employing short vol strategies, changing the market ecosystem permanently.
Following this short example of how you can apply and combine mental models, I will share some models which I assess as the most valuable. This list can be extended by any number of examples. Please refer to the links provided at the end of the article for additional resources.

First principles thinking

The mental model of “first principles thinking” describes how one deconstructs problems into their basic components. These components are then used to build up a solution for the problem at hand. First-principles thinking is contrary to thinking by analogy, which is used most in our society. By reasoning from first principles, one can come up with far more innovative solutions to a problem because established paradigms are ignored. A brilliant example of first principles thinking is given by Elon Musk in this short interview.
One of the most important first principles of finance is “there is no free lunch”. To earn a return on your investment you have to assume some kind of risk. When analyzing an investment ask yourself:  What are the risks regarding this investment? Am I compensated well for assuming the risks, especially with respect to opportunity costs?
When there is no intelligent answer to this kind of question, the odds are high that you won’t earn the expected return, or even worse, the investment will blow up in your face.

Probabilistic thinking

In my opinion, this is one of the most important mental models, if you aspire to improve your decision-making process.  When applying probabilistic thinking, one tries to assign reasonable probabilities to a set of future outcomes corresponding to all possible sets of actions. To deduct reliable probabilities you have to consider the base rates of the respective problem at hand. For example ask yourself: How did similar situations, regarding the conditions and opportunity set, play out in the past? Based on this, what is the most likely outcome going forward? Base your assessment only on facts and separate them from underlying narratives!
It is extremely hard if not impossible to assign fixed probabilities to specific outcomes. Therefore I try to tilt the odds in my favor.  When someone asks me if stocks or interest rates will move higher or lower in the future, I will answer “I don’t know! But based on the opportunity set at hand and historical base rates I assume x is more likely than y and therefore I’ll position my portfolio according to it”
If you are keen to learn more about probabilistic thinking, you will be delighted to watch the conversation with poker champion Annie Duke on making smart bets.

Laws of thermodynamics

The laws of thermodynamics provide numerous possibilities of connection to business and financial markets. The most practical one is the first law of thermodynamics which in its essence states, that the energy of an isolated system is constant and can neither be destroyed nor created.
This can be wonderfully transferred to investing, as Corey Hoffstein of Newfound Research put it Risk can not be destroyed only transformed”! For example, when you try to avoid a particular risk ( by hedging it) you introduce a new one (losing capital due to paying an option premium). This metaphor is particularly useful when evaluating risk/return tradeoffs. What kind of risk am I taking or avoiding at what cost? What am I losing or gaining in return?
You will gain more insights into the transformation of risk by listening to the conversation between Meb Faber and Corey Hoffstein.

The concept of leverage

Anyone in the financial community is familiar with the concept of leverage, nevertheless, I’d like to add this mental model to my list. A lever can be thought of as a device that increases the force applied to an object. To put it in more general terms,  a point of high leverage can be found, when small actions can make a huge difference in outcomes. One should focus on the problems where the inputs lead to the greatest results.
With respect to financial markets, leverage can increase good outcomes but reduces room for error when things go bad. It can make or break one’s existence and should be applied with caution. Leverage can be used explicitly via debt or implicitly via investment structure or derivatives. When evaluating investment strategies, it is crucial to understand the sources and uses of leverage.
Warren Buffett brilliantly describes the effects of leverage in this interview.

Regression to the mean

The mental model of regression to the mean can be found in nearly every aspect of our daily lives and its importance can not be overstated. In brief, the concept describes the occurrence of extreme outcomes which are followed by less extreme ones. For the effect to materialize, there need to be imperfect correlations between two objects which causes the true value of observations to oscillate around the mean. The higher the skew in the distribution of observations, the more pronounced is the regression to the mean after certain observations.
This concept is especially useful when analyzing market behavior or assessing the drivers of the success of investment strategies. Often we tend to assign outcomes to dedicated events when actually regression to the mean is at work. Take for example the evaluation of an asset manager’s performance during a due diligence process. Focusing to much on past performance, instead of the investment process, leaves you wide open for bad surprises, when returns regress towards their long-term expected values. The period of regression can be so long that it is hard to identify cause and effect relationships. Therefore you have to ask yourself: “Is the current observation caused by a comprehensible action or is it due to regression to the long-term mean?”
Watch this short explanation of the effect of regression to the mean in investing!

Conclusion

Mental models can be a usefull tool to aid your decision-making process, reduce complexity, and help you think more clearly. The broader the repertoire of models you acquire, the higher the number of opportunities you can create by connecting them. When using these models, it is critical to constantly question the underlying assumptions and examine whether they are applicable in the specific case. 
They always only can be seen as guiding posts! It is not the intention to blindly adhere to them.

Additional resources

A System to boost productivity

Boosting productivity

The improvement of productivity is a battle many people keep struggling with.

This battle isn’t won in a single day but needs constant effort. Every day there will be new challenges testing your resilience to outside forces that may distract you.

In my personal life, private and professional, I’m also struggling to be my productive best, not always winning the challenge.

I noticed recurring bad behaviors of mine like:

  • Trying to keep all tasks in my head
  • Not prioritize tasks efficiently
  • Not saying “no” enough
  • Not delegating tasks which are out of my responsibilities
  • Checking my smartphone too often
  • Exessive multi-tasking
  • Constant checking and reacting to emails

Overall, there was much room for altering my behavior to become more productive. So I started researching and implementing techniques to strive for a more productive life, which in retrospect, also reduced stress levels by a considerable amount.

I discovered the “getting things done method”, or short GTD, developed by David Allen during my quest for an effective productivity system.

In the course of this article, I’d like to explain how GTD works and give brief examples of how to apply it.

The GTD system consists of five distinct steps which, when followed correctly, will help you get more done with less stress.

Step 1: Capture

To develop trust in your system, you need to capture every task on your mind, be it personal or business-related, and store it in a trusted way. Your storage system may consist of a physical notebook or some useful app on your smartphone, this actually depends on personal preferences.

However, for the system to work effectively, it is essential that you capture every loose end floating around in your head.

For me, my smartphone works best, since there are only a few occasions when it’s not to hand. I use Evernote to capture and store tasks, as well as make them accessible from every device.

Step 2: Clarify

Before you tackle the most pressing tasks, you have to clarify what it is exactly. By asking yourself: “Is this item actionable or not?” you sort tasks in two categories “actionable” and “not actionable”.

The latter category is easy because unactionable items go either in the trash bin or are stored and reviewed later, in-kind they may be of use someday.

The actionable items are the ones you want to focus on!

In case, the item is a project, consisting of many actionable steps over a longer period of time, you put it on the “projects list” and decide on the next physical actions to come closer to its completion.

Simple single tasks may be “write an email to a business partner” or “gather data for your financial model”.

After labeling items as projects or tasks, you have to decide on the time horizon and your ability to complete them.

So you can:

  1. Do it yourself, if you are the right person for the job and able to complete it in less than two minutes
  2. Delegate it, if you think someone is more suited to complete it
  3. Defer it, which include scheduling the task in your calendar for later completion

Step 3: Organize

After getting clear about what tasks you have at hand, you can organize them. As I mentioned before, non-actionable items go to the trash bin or the storage system for later review.

To organize the actionable items you need a “projects list”, which consists of multi-action processes and is used to derive the next actions.

In addition, you need a “next actions list” where you collect all physical actions you need to complete to move ahead.

Lastly, a “waiting for list” is needed where you store all actions you are waiting for to be done by others. All these lists can now be used to schedule tasks in your calendar and process them one at a time.

Step 4: Reflect

Frequent reflection of your workflow management system is essential to keep it clean and up to date. The daily review of tasks on your calendar can be supplemented by weekly reviews of your overall system to see whether it is still working.

Step 5: Engage

The fifth stage is essential for pushing projects and next actions forward. You actually need to decide which task to tackle first and which to postpone for late completion. In his book, David Allen suggests you can take at least three different perspectives on your tasks.

 

a) The four-criteria model to choose actions in the moment: 

Context:

Is it possible to complete the items in the current set-up? Are you at work or at home?

Time available:

Is there enough time available to complete it? In case you have an important call in 15 minutes, you don’t need to start a time-consuming task now.

Energy available:

Do you have enough energy available to complete it? After crunching complex models for several hours, starting a new complex project may not be the best idea.

Priority:

Which of your tasks would give you the highest pay-off if completed?

 

b) The threefold-model for identifying your daily work:

 For me, it is helpful to clarify what kind of work I am doing.

Doing pre-defined work:

Solving tasks which were previously clarified and scheduled fall in this category. Doing pre-defined work helps you push things forward.

Doing work as it shows up:

It is inevitable to deal with important ad-hoc tasks, which show up during the day but are not directly contributing to the progress of your projects.

Defining your work:

In case you are not working on some scheduled or ad-hoc tasks, you may define what you have at hand during the “clarify” step. 

c) The six-level Model for reviewing your own work:

There are different altitudes from which you can view your next actions. The higher the altitude, the more it impacts every decision you make.

Horizon 5: Purpose and Principles

What are your core beliefs and principles? This category tends to drive all decisions in other categories.

Horizon 4: Vision

What is your plan for the next 5 years? What is your long term vision regarding personal, business and financial matters?

Horizon 3: Goals

What are the goals you want to achieve in the next one to two years? These define the areas you want to focus on most.

Horizon 2: Areas of focus and accountabilities

Balancing all your areas of focus and accountabilities towards your family and business partners is important to sustain long term performance.

Horizon 1: Current Projects

The current projects are derived from your areas of focus and are responsible for the majority of the tasks on your “next actions” list.

Ground: Current Actions

This level consists of all the next actions you have to take (e.g. write the sales proposal or feed the data into your financial model) to push the items on higher altitudes forward.

When you are able to be aware of the three perspectives I just mentioned, you just leaped a step forward to being more in control of your “next actions” list.

Hopefully, you can implement some of the principles mentioned above in your life and increase productivity by a vast amount.

I will keep you up to date regarding my daily struggle of increased productivity.

Below you’ll find five additional tips, which may be useful for your daily life!

 

On compounding knowledge

“Knowledge is power. Information is liberating. Education is the premise of progress, in every society, in every family”.

-Kofi Annan-

 

I recently read Reid Hoffman’s insightful book “The Start-Up of You” wherein the path of one’s career is described similarly to building and running a start-up. Especially the concept of growing your professional skill set as well as building a deep professional network has resonated with me.

In the course of reading the book, one idea I had in my head for several months and has been discussed extensively in the financial blogosphere started to dawn on me again.

 

The concept of compounding knowledge…

Albert Einstein once called the concept of compounding the eighth wonder of the world. As a finance professional, I’m quite accustomed to the effects of compounding on financial assets, but only recently have I become aware of the importance of this effect on acquiring knowledge and applying it to practical problems.

To gain a better understanding of my train of thought, I’d like to start with a habit I’ve picked up over the last five years and further cultivated since working full time as a Portfolio Manager.

I set out my goal to accumulate as much knowledge as possible each day by listening to podcasts or reading books, blogs, and research papers.

On any given day I start my knowledge gathering activities when commuting to work by listening to my favorite podcasts on finance & economics, entrepreneurship or sociology.

After arriving at my workplace I dedicate the first one and a half-hour of my workday to a deep reading of research on various aggregators like Abnormal Returns or Quantocracy and a diverse set of other authors of financial research. (My all-time favorites are Aswath Damodaran, the Macro Tourist, and Epsilon Theory)

At first, I felt unproductive because reading general research didn’t contribute directly to getting rid of the daily workload. After a while, I noticed small changes in my way of dealing with new tasks especially when the objectives were unspecific.

Not exactly knowing where these changes came from, I was slightly confused. It seemed, that I subconsciously used my knowledge reservoir during the problem-solving process to view the tasks at hand from different angles and come up with fresh solutions. Not only seemed the rapid acquisition of knowledge to bear fruit, but the effect seemed to accelerate over time. The theoretical knowledge connected with my practical experience and created a feedback-loop that fed on itself.

This was the first time I experienced the compounding knowledge-effect first hand. Since then I upped my knowledge acquisition game and try to read as many books, listen to as many podcasts as I can and try to incorporate these ideas in my daily work.

I can’t encourage anyone enough to start compounding their knowledge and use it in their professional as well as personal lives. The rewards will be mindblowing!

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